The Impact of External Debt on Economic Growth in Highly Indebted Developing Countries

Transcription

1 University of Nebraska at Omaha Student Work The Impact of External Debt on Economic Growth in Highly Indebted Developing Countries Asaad Najib University of Nebraska at Omaha Follow this and additional works at: Recommended Citation Najib, Asaad, "The Impact of External Debt on Economic Growth in Highly Indebted Developing Countries" (2005). Student Work This Thesis is brought to you for free and open access by It has been accepted for inclusion in Student Work by an authorized administrator of For more information, please contact

2 The Impact of External Debt on Economic Growth in Highly Indebted Developing Countries A Thesis Presented to the Department of Economics And the Faculty of the Graduate College University of Nebraska In Partial Fulfillment Of the requirements for the Degree MASTER OF ARTS IN Economics University of Nebraska at Omaha By Asaad Najib April 2005

3 UMI Number: EP73503 All rights reserved INFORMATION TO ALL USERS The quality of this reproduction is dependent upon the quality of the copy submitted. In the unlikely event that the author did not send a complete manuscript and there are missing pages, these will be noted. Also, if material had to be removed, a note will indicate the deletion. Dissertation Pobli'sMng UMI EP73503 Published by ProQuest LLC (2015). Copyright in the Dissertation held by the Author. Microform Edition ProQuest LLC. All rights reserved. This work is protected against unauthorized copying under Title 17, United States Code ProQuest' ProQuest LLC. 789 East Eisenhower Parkway P.O. Box 1346 Ann Arbor, Ml

4 THESIS ACCEPTANCE Acceptance for the faculty of the Graduate College, University of Nebraska, in partial fulfillment of the requirements for the degree of Master of Arts, University o f Nebraska at Omaha. Committee Chairperson Date

5 The Impact of External Debt on Economic Growth in Highly Indebted Developing Countries Asaad Najib, MA University of Nebraska at Omaha, 2005 Advisor: Dr. Kim Sosin Abstract This study investigates the relationship between external debt and the growth rate of GDP per capita based on a total sample of 57 countries consisting of two different groups. The first group is classified as Highly Indebted Poor Countries (HIPCs) because they qualify for HIPC debt relief initiative. The second group includes some middle income developing countries not qualifying for HIPC debt relief initiative. The study uses panel data with different methods of estimations. The results of this study indicate that the coefficients of debt variables were strongly significant and negatively related to economic growth, not only in the first group but in the second group as well.

6 Table of Contents Page List of Tables List of Appendix Figures List of Appendix Tables Introduction... 1 Chapter 1: Debt Problem The causes of debt problem...! Oil prices Interest rates Military expansion Economic mismanagement...12 Chapter 2: Traditional Debt Relief Mechanisms Non-Paris Club debt relief James Baker plan Brady plan Paris Club debt relief Multilateral debt relief HIPC initiative... 17

7 Chapter 3: Theory of Debt and Economic Growth An overview of empirical studies Chapter 4: Econometric Model and Data Econometric model Data Chapter 5: Estimations results Conclusion and policy implications References Data Appendix... 65

8 Figures and Tables List of tables Table 1 Predicted effects of independent variables Table 2 Debt/GDP: Impact on economic growth, Table 3 Debt /GDP: After correction for serial correlation, Table 4 Debt services/exports: Impact on growth, List of Figures Appendix Figure 1 Figure 2 Figure 3 Total debt ratio of GNP in HIPCs and other developing countries Total debt services as a ratio of exports goods and services The relation between debt and GNP (debt overhang) Figure 4 Plot of dependent variable and total debt ratio to GDP, 1977 Figure5 Plot of dependent variable and debt services to exports, 1977 Figure 6 Plot of dependent variable and total debt ratio to GDP, 1977 Figure 7 Plot of dependent variable and debt services to exports 1977 Figure 8 Plot of dependent variable and total debt ratio to GDP, 1983 Figure 9 Plot of dependent variable and debt services to exports, 1983 Figure 10 Plot of dependent variable and total debt ratio to GDP, 1983 Figure 11 Plot of dependent variable and debt services to exports, 1983

9 List of Tables Table 1 Table2 Total external debt/gross National Product Total debt service/total exports Table3 Indictors of external debt, non-oil developing countries, Table 4 Table 5 Table 6 Impact of oil prices on debt of non-oil developing countries Impact of exogenous shocks on external debt of non-oil developing Paris Club rescheduling by type of terms of HIPC countries Table 7 Summary statistic, 1977 Table 8 Summary statistic, 1983 Table 9 Correlation matrix, 1977 Table 10 Correlation matrix, 1983 Table 11 Total debt/gdp: Impact on economic growth, HIPC, Table 12 Debt services/exports: Impact on economic growth, HIPC, Table 13 Total debt/gdp: Effect on economic growth, non-hipc, Table 14 Debt services/exports: Impact on economic growth, non-hipc,

10 1 Introduction This study investigates the impact of external debt on economic growth in two groups of highly indebted developing countries. In the mid -1980s, the worsening financial situation in a number of developing countries reached a critical peak, when highly indebted poor countries were unable to continue to pay their debt. The developing countries debt rose from $500 billion in 1980 to $1 trillion in 1986 and approximately $2 trillion in 2000 (IMF, 2001). This debt crisis is indicated by a number of statistical debt measures. The developing countries ratio of debt to debt servicing abilities worsened as debts increased, particularly after As Table 1A shows, the ratio of debt to GNP in Least Developing Countries (LDC) increased from 14 percent in 1970 to 39.6 percent in 1987 and 37.7 percent in In Middle Income Countries the ratio was 39.2 percent in 1987 and declined to 36.5 percent in In Severely Middle Income Countries (SMIC), the ratio reached the highest in 1986, 62.3 percent, and decreased to 39.3 in Table 2A provides the ratio of debt services to exports, rising from 13.2 percent in 1982 to 23.7 in 1987 and after that declining to 18.3 percent in The ratio reached 16.3 in The factors behind the growth of foreign debt in developing countries are varied and include a combination of internal and external factors. A number of studies in the literature, for example, William R. Cline (1984), Milton A. Iyoha (1999), and Haji H. H. Semboja (1998) have summarized these factors to include both demand and supply sides. On the demand side, there was a vital need in oil-importing developing countries for foreign exchange in order to finance balance of payment deficits and public projects

11 2 following the increase of oil price in the 1970s. These are joined with other domestic factors, such as high trade and budget deficits, low savings rates, the lack of sensible debt management, and poor project selection. On the supply side, the oil price shocks, high interest rates, and recessionary conditions in the developed countries forced the international banks to recycles their huge petro-dollar deposits through increasing loans to developing countries. Because of low levels of external demand associated with world recession and reductions in international lending, the average growth rates of non-oil developing countries fell from 5 percent in to 2.4 percent in 1982 and to only 0.9 percent in 1982 (Cline, 1984) Cline argued that debt problems not only effected growth in developing countries and created unstable international financial systems, but also contributed to reduced exports and jobs in industrial countries as developing countries have retrenched on their imports. From 1981 to 1982 exports of OPEC (Organization for Economic Cooperation and Development) countries to non-opec countries declined by $14 billion in real terms, an amount corresponding to approximately 350,000 jobs.1 US exports to Latin American countries fell by $24 billion from 1981 to 1983, costing approximately 400,000 jobs (Dhar, 1983; Cline, 1984). The discussion of the relationship between external debt and economic growth in the literature has two trends. The first trend is represented by Sachs and Kenen (1990). According to their view, the external debt overhang is a main cause of stunted economic growth in heavily indebted countries. For this reason, debt reduction and international 1IMF, International financial Statistics, June 1983 p. 56; OECD, Monthly Statistics of Foreign Trade, June 1983, PP 37, 42, 49. William R.

12 3 debt relief program facilities are needed. The beginning of the debate about the effect of public external debt on economic growth is from Paul Krugman (1987). According to Krugman, high governmental debt services payments require high tax rates which in turn discourage capital formation and repatriation of flight capital. The heavy debt service payments have put great pressure on budgets, leading to rising fiscal deficits in the highly indebted countries. Taxes must be increased to raise the resources to service the debt. One of the consequences of the anticipated tax burden is to depress private investment leading to reduced economic growth, the debt overhang effect. High debt service payments will lead to reduced public investment and also reduced public spending on health and education, which leads to negative impacts on economic growth. The diversion of resources from public investment to debt service payments is related to the crowding out hypothesis. The second view is represented by Bulow and Rogoff (1990), who argue that the external debt of developing countries is a sign of poor economic management and performance rather than a primary cause of stifled growth. Bad domestic policy management, such as overvalued exchange rates, disadvantages the private sector in earning foreign exchange. Fiscal deficits and fear of inflation and taxes to finance actual and anticipated deficits scare away private investment. Since the crisis of 1982 various plans and initiatives have been presented to provide debt relief to the most indebted developing countries. An example known as traditional debt relief, the Brady plan, encouraged the rescheduling of loans by converting

13 4 them into bonds that could be sold in the secondary market giving debtors more time to pay (Vasquez 1996). Progress has been made on bilateral debt through the Paris Club, an informal grouping of the Export Credit Department of the main creditor countries. At first Paris Club creditors agreed to reduce low-income countries debt, the net present value of rescheduled amount, by one third (Toronto Terms). The degree of debt forgiveness was increased in several steps. By the early and mid-1990s, under the London Terms and Naples terms, Paris Club creditors were forgiving 50 percent and 67 percent, respectively, of the low income countries eligible debts. However, the external debt situation for a number of low income countries was still extremely difficult, leading the International Monetary Fund and International Bank to provide the most comprehensive effort, known as the HIPC (Highly Indebted Poor Countries), initiative in The aim of the HIPC initiative was to provide special assistance and a broad framework of debt relief to a number of very poor countries for whom traditional debt relief was not enough to bring down their debt burden to a sustainable level. At the same time the countries which qualify for HIPC initiative agreed to reform economic programs. Contrary to traditional debt relief mechanisms, the HIPC initiative included the relief of debt owed to the multilateral institutions like IMF and World Bank. Forty-one countries have been classified as eligible for the HIPC group. The debt of these countries grew from $59 billion in 1980 to $105 billion in 1985 and $190 billon in 1990 (IMF, 2000). As Figure 1A in the Figure Appendix shows, the average debt to GNP ratio increased from 75 percent in to about 110 percent between and to

14 5 approximately 140 percent in The average debt to exports ratio increased from 210 percent in to about 440 percent in (Figure 2A in the Appendix). However, the external debt problem was not limited to the countries qualifying for HIPC. Countries that were supposed to have sustainable debt burdens also suffered from increased debt service payments leading to increased taxes and reduced government spending. The result of this situation was a cancellation of some domestic development projects leading to negative impacts on economic growth. The objective of this study is to investigate the impact of external debt on economic growth on two groups of developing countries. The first group contains 33 highly indebted poor countries which qualified for HIPC initiative. The second group consists of 24 developing countries that did not qualify for HIPC but did have debt burdens2. The study investigates the argument that a negative relationship between external debt burden and economic growth is not only true of the highly indebted poor countries receiving help from HIPC imitative, but also of a group of developing countries that don t qualify for HIPC initiative. This study uses panel data for 57 countries for the period 1971 to After this introduction, the remainder of this study is divided into six chapters. The first chapter provides a brief overview of the debt problem and analysis of the determinants or causes of the debt crisis. Chapter two will deal with the traditional mechanisms of debt relief, the HIPC initiative, and a brief evaluation of the HIPC in relation to economic growth. Literature review on the role of external debt in economic 2 World Bank Classification, available in

15 6 growth will be provided in chapter three. The model specification and data description are presented in chapter four, the empirical results will be explained in chapter five. Conclusions and policy implication of findings will be provided in chapter six.

16 7 Chapter 1: Debt Problem During the three decades beginning in the 1950s, deficits in the current account were considered normal. Countries were encouraged to borrow abroad and create an environment conductive to foreign investment to enhance their economic growth. In the practice little attention was paid to the liabilities side of the current account deficit, which increased the external indebtedness of these countries. In 1980, the world experienced a debt crisis in which highly indebted Latin America and other developing regions were unable to repay the debt. The problem exploded in August of 1982; as Mexico declared the inability to pay the interest on its debts to commercial banks, the International Monetary Fund, and the World Bank (Were, 2001). Soon, other countries including Brazil, Argentina, Bolivia, Venezuela and finally the Philippines, followed Mexico. There are several schools of opinion about the debt crisis. One school maintains that lenders brought the crisis upon themselves as a result of excessive lending (Semboja, 1998). Another school of thought attributes the debt to the rise of oil prices and deflationary policies pursued by the developed world (Iyoha, 1999). Another group of researchers maintains that the commercial nature of the debt and the inherent instability of world capital markets are the major causes of debt crisis. According to Stambuli (1998), this view implies that it is necessary to check and regulate the flow of funds to the developing countries to match their requirements for development and create the capacity to finance repayment of loans.

17 8 Sachs and Radelet (1998) argue that the debt crisis was caused by both the debtors and creditors as a result of their miscalculations. Thus, cooperation between both sides is needed. 1.2 The causes of the debt problems The major causes of the debt problem include both external influences and factors internal to the debtor country. The external factors of the debt problem were high oil prices in and , high international interest rates, and the global recession in The main internal factors included domestic budgetary policy, and economic mismanagement Oil prices The increases in oil prices created huge current account surpluses for OPEC members, and billions of dollars were transferred to OPEC members from oii importing countries. Until the late 1970s, banks in developed countries experienced a trend increase in deposits associated with underlying growth in Western world. However, in the late 1970s, the growth rate of deposits in most banks in developed countries was between 25 and 30 percent (Weintraub, 1984). Weintraub points out that most these deposits were created from excess foreign assets of oil companies in the gulf region._on the other hand, banks in developed countries preferred to lend to developing countries rather than to their own markets because the demand for loans by businesses in western countries decreased as a result of increasing real wages in the late 1970s (Weintraub, 1984 ).

18 9 The trade surplus of OPEC member countries increased from only $7 billion in 1973 to $68 billion in 1974 (Weintraub, 1984). In the mid-1970s, OPEC members used their surpluses to purchase deposits. These deposits allowed banks to expand their lending to non-opec developing countries, who in turn increased their credit demands as a result of increased oil prices and the need for these loans to finance their current account deficient. However, when the current account surpluses of the OPEC countries fell in 1978 and 1982, the credit demands of non-developing countries did not decrease. Thus, oil price shocks are one of the most important exogenous factors of the debt burden in developing countries. As shown in Table 3A, the value of oil imports rose from 6 percent of total imported goods in 1973 to 20 percent in Cline (1984) provided a calculation of the cumulative additional costs of oil imports as a result of increase oil prices.3 In Table 4A, the first column shows actual net oil imports by these countries since The second column shows the amount that would have been paid for these imports if the price of oil had risen no more than the US wholesale price index after As the table shows, the cumulative total cost as result of oil price shocks is $260 billion over the decade (Cline, 1984) Interest rates The global recession and high interest rates of added enough to the burden to precipitate several major debt crises by The changes in the average real interest rates played an important role in the debt crisis. During the 1970s the real interest rate 3 See the Appendix Table 5

19 10 was low. In fact, the average was negative compared to when the average real interest rate was 4.1 percent (Cline 1984). Low interest rate during 1970s created a good environment for developing counties to borrow. By real interest rates started to increase until reaching 7.5 percent in 1981 and 11 percent in This increase in interest rates reduced cash-flow for borrowers, making the debt problem more complicated. Cline (1984) estimates the excess interest rate in as the amount by which real interest rates exceeded their average level for According to Cline, for the 1960s and 1970s real interest rates averaged 1.66 percent. In 1981 it was 7.46 percent, and in 1982 it reached percent. Thus, the excess of interest rates level above the real level was 5.8 percentage points in 1981 and 9.29 percentage points in The total debt in non-oil developing countries was $240 in 1980, $293 billion in 1981, and $329 billion in By applying the estimated excess interest costs in 1981 and 1982, the total excess interest payment was estimated by Cline (1984) as $41 billion in In , the international economy experienced severe recession leading to decreased real growth in industrial countries, to -0.3 percent in 1982, after 3.2 percent annual growth between 1973 and 1979 (IMF, 1983). On the other hand, export prices for developing countries were affected and showed considerable declines over Cline (1984) estimated the total effect from the terms of trade in was approximately $79 billion: $25 billion loss in export value and import cost increases of $9.6 billion in 1881, and a loss of export value in 1982 by $44 billion. In sum, high interest rates and global recession imposed large cumulative losses on non-oil developing

20 11 countries in In all, these countries lost approximately $141 billion in higher interest payments, lower export receipts, and higher import costs as the consequence of adverse international macroeconomic condition. (Cline, 1984 p. 13) A summary of the impact of exogenous shocks on external debt of non-oil developing countries is provided in Table 5A. As the Table shows, the total impact, as a result of the combination of oil price, real interest rate, terms of trade, and export volume loss, was to increase the debt of non-oil developing countries by $401 billion Debt because of military expansion Researchers have attempted to establish that debt has increased because of military spending. Military spending leads to increased debt through imported arms. According to Stambuli (1998), this buildup of the military is taken as a reflection of increased demand for latest military technology by third world regimes, especially those under military rule. The empirical studies of the impact of military spending are limited because of the lack of data on imported arms. However, a few studies attempted to relate external debt problems to military spending. For example, Brzoska (1983) pointed out that military spending is an important variable in explaining the rise of foreign debt and in turn reducing economic growth in several developing countries. Military expenditures created the need for funding and the resources of funding were either from domestic sources or external sources. If the domestic sources were not large enough, the solution was to borrow. Another way to link military spending to debt was that the imported arms required a foreign currency for payment; the alternative was to obtain foreign exchange from external sources by borrowing.

21 Economic Mismanagement Boulow and Rogoff (1990) argue that one of the causes of external debt in developing countries is related to the poor economic management; the main comment of governments of poor countries is that they should have responded to debt by focusing their policies towards increased generation of foreign exchange to meet future obligations for debt service. On the contrary, most developing countries adopted economic policies focusing on comprehensive ownership of the means of production that resulted in expanded public sectors (Stambuli, 1998). Most developing countries adopted industrial strategies aiming at domestic production of previously imported goods in order to be more independent and also to reduce the demand for foreign exchange. These strategies encouraged countries to invest in huge projects that need intensive capital. Given the lack of enough domestic resources, borrowing is the alternative way to finance these projects. Moreover, there are several domestic factors that play the role of building up external debt, such as the political system, corruption, the quality of bureaucracy, the level of the public sector, and the economy s degree of freedom and competition.

22 13 Chapter 2: Traditional Debt Relief Mechanisms and HIPC Initiative This chapter provides briefly the history of debt relief, starting from traditional debt relief mechanisms and ending with the initiative for highly indebted poor countries in The traditional debt relief mechanisms are defined as all measures of debt relief that are not provided in the context of the HIPC initiative, such as non-paris Club debt relief, Baker and Brady plans, and debt relief under Paris Club format, Toronto Terms, London Terms, and Naples Terms. 2-1 Non Paris Club debt relief At the peak of the Latin American debt crisis in 1985, James Baker, the USA Treasury Secretary during the Ronald Reagan period, attempted to provide a systematic approach to the debt problem. This was known as Baker plan. The main point in this plan was that loans should be increased to indebted poor countries by banks and multilateral finance institutions. The plan advocated the increase of bank lending by $20 billion. The World Bank and other multilateral finance institutions were also to increase their lending by 50 percent to a target of $9 billion. Under these proposals, $2.7 billion of IMF money was to finance new flows to the poorest countries mainly in sub-saharan Africa (Stambuli, 1999). At the same time, these countries had to agree to submit to adjustment conditions. By , it was clear that the Baker Plan had been unsuccessful at either reducing debt or allowing the target countries to grow their way out of debt as had been intended. The Baker Plan was unable to provide the proper incentives for developing countries to introduce consistent market reforms, or for banks to supply new money that would finance such reforms (Vasquez, 1996).

23 14 The Brady plan intended to be flexible in dealing with debtors and creditors by providing a set of conditions and providing alternative options (Vasquez, 1996). The first country that agreed to deal with this plan was Mexico, which then became a guide for some countries. Vasquez (1996) examined this deal with Mexican government and representatives of more than 500 banks in According to this deal, there was a set of conditions which banks could choose from to reduce or increase their exposure. Three options were available. Existing loans could be swapped for 30-year debt-reduction bonds that would provide a discount of 35 percent of face value. Existing loans could also be swapped for 30-year par bonds that would effectively reduce Mexico s debt service on those loans through a below-market interest rate of 6.25 percent. Banks could also provide new loans at market interest rates over a four-year period of up to 25 percent of their 1989 exposure. In case of the Mexican deal, banks choose to swap 49 percent of their loans for discount bonds, 41 percent for par bonds, and 10 percent to provide new money. (Vasquez. 1996). Among the countries following Mexico were Costa Rica (1989), Venezuela (1990), Uruguay (1991), Argentina (1992), and Brazil (1992). By May, 1994, 18 countries had agreed to Brady deals forgiving $60 billion of debt and representing about $190 billion in bank claims (long term). Under the plan, the World Bank and the IMF would provide $12 billion each, and the Japanese Import-Export Bank would provide about $8 billion for securitization; most of that money has already been committed for that purpose. The typical deal led to about 30 to 35 percent forgiveness of a country's debt (Cline, 1995). With respect to the relation between debt relief and

24 15 economic growth, Vasquez (1996) points out that there is no correlation between Brady Plan deals and positive economic indicators and that this plan seems to encourage a relationship between market reforms and positive indicators. 2-2 Paris Club The bilateral donor provides traditional debt relief in the form of the Paris Club. This form has improved from one stage to the next. In early1980s, Paris Club creditors provided reschedulings for low-income countries on standard terms, with relatively short five-year grace and maturity (10 years) periods with market- related interest rates. From 1976 to 1988 the Paris Club provided 81 non-concessional flow reschedulings with 27 of countries (Daseking and Powell, 1999). But low income countries continued to have difficulties adhering to the resulting repayment schedules and the rescheduling of interest led to repay debt accumulation (Boote and Thugge, 1997). By the late 1980s, Paris Club creditors recognized that repeated reschedulings on standard terms over a long period did not provide a solution to the debt problems of the low-income countries because for most of them, their debt problems required not only cash- flow relief but also debt reduction. So in late 1988, Paris Club creditors agreed to provide concessional reschedulings for low-income countries on Toronto Terms. Toronto Terms was the first initiative to provide a cancellation of the developing countries debt. The amount of forgiveness by these terms is one third from the present value of the debt qualifying for rescheduling (Stambuli, 1999). Under Toronto Terms, a grace period of eight years facilitated debt service reduction. For longer maturities, a

25 16 grace period of 14 years applied. The period of amortization was extended to 14 years (post-grace period) while longer maturities attracted 25 years. As a principle, eligibility was limited to debt service falling within the period from October 1988 to June 1991 ( Stambuli, 1999). From , 20 LIC countries received reschedulings on Toronto terms, with about $6 billion of payments falling due being either partially cancelled or rescheduled on a concessional basis (Daseking and Powell, 1999). Stambuli (1999) argues that Toronto Terms made very limited impact after four years of combined attempts at debt stock and debt service reduction, and he points out that the main weaknesses arise from the fact that debt stock reduction available under Toronto Terms was limited to 33% calculated in net present value terms while debt service reduction qualified for between 20% and 30%. Toronto Terms also excluded long maturities from debt reduction. In December 1991, a new set of terms with some improvement, London Terms, was provided by the creditors. The level of forgiveness on eligible debt in NPV (Net Present Value) was increased to 50%. The period of amortization for existing stock was increased to 23 years while new Official Development Assistant (ODA) credits attracted 30 years amortization. Under the London Terms, creditors accept that after a period of good performance, three years, they would be willing to discuss the possibility of an agreement covering the full stock of eligible debt (Deseking and Powell, 1999).4 Naples economic summit in 1994 enhanced the terms for indebted countries. Under the Naples Terms, the forgiveness of net present value of debt service payable 4 Eligible debt defined as pre cut-off date medium term debt: Daseking and Powell (1999)

26 17 during the consolidation period was raised to 67 percent. The grace period for longer maturities was extended to 20 years, and the maturities period was extended to 30 years (Deseking and Powell, 1999). Table 6A provides summary of the Paris Club rescheduling by type of terms from Multilateral debt relief The role of multilateral financial agencies under the Paris Club was to help countries create economic policy and reform programs. These programs are to be supported by concessional lending from IMF and World Bank, the former under the Structural Adjustment Facility and Enhanced Structural Adjustment Facility (Stambuli, 1999). 2-4 HIPC initiative In September 1996, at their Annual Meeting, the IMF and World Bank announced the HIPC debt initiative that aims to reduce the debt burdens of all eligible HIPCs to sustainable levels. This initiative defines a country as heavy indebted if the traditional. debt relief mechanisms are not enough to reduce its external debt to a sustainable level (Gunter, 2002). The HIPC initiative evaluates traditional debt relief as being too weak to raise the debt to sustainable level for heavy indebted poor countries. The difference is that HIPC initiative includes, for the first time, a cancellation of multilateral debt such as the debt from World Bank and International Monterey Fund. The initiative s goal is the reduction of eligible countries external debt burdens to sustainable levels and

27 18 elimination of any debt overhang that might be a hindrance to growth and investment (Sun, 2004). Compared to decades of bilateral debt rescheduling, Gunter (2002) argues that the HIPC initiative was a major advance for two related reasons. First, it was intended to be a comprehensive solution to unsustainable debt problems which would free HIPC countries from repeated debt rescheduling by reducing their external debt stock to sustainable levels. Second, given that increasingly external debt owed by the HIPCs was multilateral debt, the HIPC initiative included a reduction of multilateral debt. Further, three years after launching the initiative, the original HIPC framework was enhanced by the IMF and World Bank in September, The enhancements provide broader, deeper, and faster debt relief (Lisandro and Ross, 2001). To qualify for assistance under the HIPC initiative, the debtor country under review must adopt adjustment and reform programs supported by IMF and World Bank and pursue those programs for three years (Hjertholm, 1999). During that time, it will continue to receive concessional assistance from donors and multilateral agencies, as well as debt relief from bilateral creditors. A group of 41 countries were identified as HIPC in Since then Nigeria and Guinea have been removed from the initial list, while Malawi and the Gambia were added to the list as the NPV of their external debt was found to be unsustainable (Cassimon and Renard, 2002).5 As described earlier, the HIPC initiative was adopted in 1996 with the goal to provide a permanent exit from repeated debt rescheduling. Though the HIPC initiative 5 The countries are Angola,Benin, Bolivia, Burkina Faso, Burundi, Cameroon, Central African Republic, Chad, Congo, Conte d Ivoire, Democratic Republic of the Conge, Ethiopia, Gambia, Ghana, Guinea, Guinea-Bissau, Guyana, Honduras, Kenya,Lao PDR, Liberia, Madagascar, Malawi, Mali, Mauritania, Mozambique, Myanmar, Nicaragua, Niger, Rwanda, Sao tome and Principe, Senegal, Sierra Leone, Somalia, Sudan, Tanzania, Togo, Uganda, Vietnam, Yemen, and Zambia.

28 19 had been enhanced in 1999, Gunter (2003) argues that there is mounting evidence that the enhanced HIPC initiative does not even provide short-term debt sustainability for many of the poor and highly indebt countries. Gunter states that a United State General Accounting Office report reviewed the HIPC initiative in spring 2000 and concluded that without strong and sustained economic support?, the initiative is not likely to provide lasting debt solutions (US GAO, 2000).

29 20 Chapter 3: Theory of Debt and Economic Growth Based on a literature review relating the effect of a heavy foreign debt burden on economic growth, the dominant paradigm is the debt overhang hypothesis. This hypothesis has two versions. According to the traditional version, private agents in the debtor country see a very high debt burden as a future tax on the return to capital (Krugman, 1987). The heavy debt burden means that government will have to increase taxes in the future to finance the high debt service payments. Increasing taxes means decreased return on capital lending, discouraging private investments, which in turn leads to lower economic growth. The other approach argues that government will engage in inflationary financing as a result of excess demand for foreign currency created by debtservicing needs (Serieux and Sarny, 2001). So a public debt overhang can effect macroeconomic stability through several channels: an increase in the fiscal deficit, exchange rate depreciation, monetary expansion and inflation from monetizing debt service obligations, and exceptional financing needs such as payments arrears and debt rescheduling. These tend to maintain uncertainty about the future debt-servicing profile of the public sector (Hjertholm, 1999). Borensztein (1990) defines debt overhang as follows: The debt overhang arises in a situation in which the debtor country benefits very little from the return to any additional investment because of debt service obligation. When foreign obligations cannot be fully met existing resources and actual debt payments are determined by some negotiation process between the debtor country and its creditors, the amount of payments can become linked to the economic performance of the debtor country, with the

30 21 consequences that at least part of the return to any increase in production would in fact be devoted to debt servicing. This creates a disincentive to investment from the point of view of the global interest of the debtor country. (Borensztein, 1990: 316). Karagol (2002) argues that the debt overhang is based in the premise that if debt will exceed the country s repayment ability with some probability in the future, expected debt services is likely to be an increasing function of the country s output level (Karagol, 2002: 41). So the taxes will affect the return of domestic investment and discourage a new domestic and foreign investment. Sachs (1990) and Kenen (1990) argued that the external debt overhang is the major cause of stunted economic growth in heavily indebted countries. The reasons for this are the following: first, the required debt service payments for some countries are so large that the country is unlikely to return to a growth path. Second, a large debt overhang slows private investment and government adoption of adjustment programs because of uncertainty and adverse incentives. The debilitating effect of external debt on economic growth is explained by Krugman s (1987) argument that high governmental debt service payments require high tax rates, which in turn discourages capital formation and return of flight capital. The above view is also supported by Dornbusch (1988), who argues that since the government does most of the debt service payments in the highly indebted developing countries, currency devaluation will have a small effect on the trade balance. Thus, the debtor country shares in any increase in output and exports because a part of that increase will be used to service the external debt. The theory implies that debt reduction will lead to

31 22 increased investment and repayment capacity and, as result; the portion of the debt outstanding becomes more likely to be repaid. When this effect is strong, the debtor is said to be on the wrong side side of the debt Laffer curve. The debt Laffer curve relates the amount of debt repayment to the size of debt. The idea of Laffer curve implies that debt accumulation stimulates growth over some range, but there is a limit beyond which growth is not stimulated by debt (Elbadawi et al., 1996). As shown in Figure 3A, the relationship between debt and growth is positive in the lift side of Laffer curve and negative in the right side of the curve (Gunter, 2001). In summary, the impact of external debt on economic growth could come through the fiscal account because a significant portion of government revenue must be given over to debt servicing. Other areas of government spending will be reduced to face the obligation of debt service, with one area being public investment. This fiscal effect is known as the crowding-out effect (Serieux and Sarny, 2001). External debt can also have an effect on growth through the external account. The debt services obligation Creates a demand for foreign currency. In the absence of substantial reserve coverage or high exports, higher debt service payments mean reduced import capacity leading to a negative impact on growth. This effect through the external account is called import compression (Serieux and Sarny, 2001). 3-1 Empirical studies There have been several attempts to empirically assess the external debt-economic growth link, the debt overhang and crowding out effects, primarily by using OLS and different debt indictors as a measures of debt, for example, the ratio of total debt to GDP

32 23 and ratio of debt services to exports. Most of the empirical studies include a fairly standard set of domestic, debt, policy and other exogenous explanatory variables. The majority of these empirical studies find at least one or more debt variables to be significantly and negatively correlated with investment or growth. For instance, Fischer (1991) examined the relationship among some macroeconomic variables and the growth rate of per-capita real GDP for the period of 1970 to He found that the coefficient of foreign debt is negative but not statistically significant in the cross-sectional analysis. Borensztein (1990) found that the debt overhang had an adverse effect on private investment in Philippines. The effect was strongest when private debt rather than total debt was used as a measure of the debt overhang. Iyoha (1999), using data from 1970 to 1994, investigated the impact of external debt on economic growth in Sub-Saharan African countries using a small macroeconomic model that permits simulation of the effect of external debt on economic growth. The simulation model consists of three equations. Two of them are related to the production function and investment demand and the third one is the debt accumulation identity. The debt variables used in this study are the ratio of debt to GNP as a measure of debt overhang and the ratio of debt services to export as a measure of the crowding out effect. The coefficients of both the debt to GNP and debt services to export ratios have negative signs and are significant at the 1% level. An important finding in the Iyoha study is a confirmation of the debt overhang hypothesis and the existence of a crowding out effect in Sub-Saharan African. He concludes that a heavy debt burden acts to reduce investment through both the debt overhang and the crowding out effect.

33 24 Clements et. al. (2003) examine the channels through which external debt affects growth. They use panel regressions and data for 55 low-income countries for the period This study uses two equations, growth and public investment as dependent variables with a set of controlling variables as independent variables, including debt indicators like the face value of the stock of external debt as a share of GDP, the net present value (NPV) of the stock of external debt as share of GDP, the face value of the stock of external debt as share of exports of goods and services, and the net present value of debt as a share of exports of goods and services. This study used fixed effects and system GMM. The results provide support for the debt overhang hypothesis and crowding-out effect. According to the result of the study, debt has a deleterious effect on growth only after debt reaches a threshold level. The study estimates the threshold level at around 50 percent of GDP for the face value of external debt, and at around percent of GDP for its estimated net present value and percent of exports. The study showed that debt service has a negative impact on growth through public investment and the relationship is nonlinear: on average, every 1 percentage point increase in debt service as share of GDP reduces public investment by 0.2 percentage points. Along the same lines, Serieux and Sarny (2001) studies the relationship between debt and growth. The aim of this study is to distinguish the channels through which debt effects growth. This study uses panel data for cross section of 53 low and lower middle income countries for the period The estimation is based on three equations, an investment equation, a human capital equation, and a growth equation. In the j

34 25 investment equation, the coefficients of debt to export and debt services to export were negative and significant at 1% level but the coefficients of debt to revenues and debt services to revenues were insignificant. The exported-related debt variables become insignificant when included with revenue related variables. This result, according to Serieux (2001), supports the import compression effect and debt overhang hypothesis. In the human capital equations, the coefficients for the debt services to exports were significant and negative in both equation secondary and primary school. However, the coefficient of debt services to revenue was negative and significant in secondary school equation only. In the growth equation, both coefficients, debt services to exports and debt services to revenues, were negatively related to growth and significant at 1%. Both results, in the investment equation and growth equation, seem to support the crowding out and the import compression theories. Elbadawi et. al. (1996) also confirmed a debt overhang effect on economic growth In their study using cross-section regression for 99 developing countries in Sub- Saharan Africa (SSA), Latin America, Asia, and Middle East, they identified three direct channels through which indebtedness in SSA works against growth: current debt inflows as a ratio to GDP, past debt accumulation and debt service ratio. The fourth indirect channel works through the impacts of the above channels on public sector expenditures. They found that debt accumulation discourages growth while current debt inflows encourage growth. Their results also showed that the debt burden has led to fiscal pain as evidenced by severely compressed budgets (Were, 2001).

35 26 Hansen (2001) investigates the impact of aid and external debt on growth and investment in developing countries. The study uses cross-country regressions and data for 54 developing countries for the period The ratios of total debt to GDP and debt services to exports are used as a measure of debt in both equations. Aid is measured as total development assistance in current US$ as a percentage of GDP. When the study regresses the GDP per capita on initial GDP per capita, total aid to GDP, foreign direct investment, institutional quality, and dummy for Sub-Saharan Africa, it finds that both coefficients, debt to GDP and debt services to exports ratios, are negative and significant at 10% level, whereas, the coefficient of aid is positive and significant. When the study added several policy indictors like budget surpluses, inflation, and openness, the coefficients of debt became insignificant with no change for aid coefficient. In the investment equation, when the study includes all the variables related to aid and debt, the coefficient of aid and debt ratio are insignificant, but the debt services ratio was negative and significant. In summary, this study found that there is a quite strong evidence of positive impact of aid on both growth per capita and investment rate. A negative impact of debt and debt services on investment and growth were empirically supported. The results confirm that both the debt overhang hypothesis and crowding out effects exist. These results are consistent with the findings of the prior studies such as Elbadwai et. al. (1996) and Serious (2001) Cohen (1993) finds no evidence for the general existence of a debt overhang using data for sample of 81 LDCs. Yet, for the Latin American countries, the study shows that high debt had a negative impact on their growth. This result is reconfirmed in a later

36 27 study by the same author (Cohen, 1997). This study also clearly finds that for African countries high debt is not a major cause for low levels of economic growth in the 1980s and 1990s. Classens (1990) finds a debt overhang for only a very limited number of LDCs. Oks and VanWeinberger (1995) test the debt overhang hypothesis for Mexico and conclude that it does not exist. Deshpande (1997) investigates the relationship between debt and economic growth in a sample of 13 countries, finding that the debt overhang does exist. External debt is found to exercise a negative influence on the investment ratio. For the period , the investment ratio for the sample countries displays first a rising tendency and then declines to the end of the eighties. The regression results show that while the relationship between the debt ratio and the investment ratio continues to be negative in both the periods, there are some favorable time factors that exercise a strong positive effect on investment in the first phase ( ), and then negative effect of debt on investment in the second phase ( ). Using time series data for the period , Were (2001) investigates the impact of external debt on economic growth and investment in Kenya. The study uses three debt variables, current flow of debt as a ratio of GDP, past debt accumulation (debt lagged) as a ratio of GDP, current debt services to exports, and accumulation debt services as a ratio of exports (lagged debt services). In the growth equation, the coefficient of both the total debt to GDP and lagged total debt to GDP were negative and significant at 5% level. These results provide some verification of the debt overhang hypothesis and indicate that even current debt flows have negative impact on growth, in the short run. Contrary to the expectations of the study, the coefficient of debt services to

37 28 exports in the growth equation was positive and significant at 5% level. This unexpected result, according to the author, suggests that Kenya does not have a high level of debt services compared to the rest of low income countries. Another reason for Kenya s differences compared to other countries relates to the structure of the debt, in which a greater proportion of Kenya s external debt consists of official debts. The interest rate applied in this kind of debt is not high compared to commercial debt. In the investment equation, the coefficient of the current debt flows has positive sign and is significant at the 5% level, whereas accumulation debt has a negative relation to investment, also significant at the 5% level. These results provide strong support for the crowding-out effect and debt overhang theories. Lin and Sosin (2001) examine the relationship between external debt and economic growth based on the total of 77 countries. This study uses a data sample from 1970 to The debt variable is the average ratio of foreign debt to GDP from 1970 to In contrast to other studies; this study investigates four different regions.6 The study uses cross section regressions, an annual growth rate of per capita real GDP as dependent variable and the ratio of debt to GDP as an independent variable, including initial per capita real GDP, ratio of real government consumption to GDP, ratio of real investment to GDP, average population growth, and dummy variables for both Africa and Latin American. The coefficient of the external debt variable in the whole sample is negative and significant at 5% level in four equations, indicating that external debt has negative impact on the economic growth. When the study adds government spending to 6 Among them 18 industrialized countries.